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2021 | OriginalPaper | Buchkapitel

A Rule-Based Monetary Strategy for the European Central Bank: A Call for Monetary Stability

verfasst von : Juan E. Castañeda

Erschienen in: New Challenges for the Eurozone Governance

Verlag: Springer International Publishing

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Abstract

The 2020–2021 review of the ECB strategy will shape monetary policy in the Eurozone in the years to come. Crucially, it will also determine the scope and capabilities of the ECB within the ever-evolving architecture of the euro. As in the aftermath of the Global Financial Crisis and the subsequent Euro Crisis, Member States are discussing new mechanisms to enhance economic recovery and further integration which, one way or another, will involve the support of, or the coordination of fiscal policymakers with the ECB. The impact of the new ECB strategy in the current debate about the future direction of the single currency should not be overlooked. In this chapter, we offer a proposal for the reform of the ECB strategy incorporating the lessons learned in the recent crises. We discuss several options for the ECB and set up a rule-based strategy suitable to operate in an environment of persistently low inflation and near-zero interest rates. Under our proposal, monetary stability becomes the guiding principle for providing macroeconomic stability over the medium and long term, as well as for enhancing the transparency of the ECB communication policies.

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Vorheriges Kapitel From Deadlocks to Breakthroughs: How We Can Complete the Banking Union and Why It Matters to All of Us

Nächstes Kapitel Searching for a New Balance for the Eurozone Governance in the Aftermath of the Coronavirus Crisis

The fear of deflation is a common feature among central banks in our days. Following Bordo and Filardo (2004), what they actually fear is an ‘ugly’ or recessive-type deflation, such as that in the Great Depression years. However, there are other (productivity-driven) ‘good’ deflations which central banks should not fight against but welcome; these are deflations where the fall in prices is the result of an increase in the supply of goods and services in competitive markets (see Selgin 1997). An expansionary monetary policy to avoid this type of benign deflation will create an excess in the amount of money in the economy and eventually destabilise the markets (see Castañeda and Wood 2011). This is an intrinsic flaw in the strategy of most inflation-targeting central banks in our days.

Of course, it is undeniable that the other areas which the ECB is looking into under the review are indeed very relevant to the understanding of the Eurozone economy and the transformations that will impact monetary policy in the future.

Such as Mario Draghi’s (former President of the ECB) statement on 26 July 2012 in support of the euro: ‘Within our mandate, the ECB is ready to do whatever it takes to preserve the euro’ (Draghi 2012).

Such as the increased macroeconomic coordination under the Macroeconomic Imbalances Procedure and the new ‘Fiscal Compact’.

See Codogno and Noord (2020) and Vaubel (2020) for further details about those both in favour and against policies and mechanisms for the mutualisation of the Member States debt in the eurozone.

‘In accordance with Article 105(1) of this Treaty, the primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, it shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2 of this Treaty. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 4 of this Treaty.’ Statutes of the ESCB and the ECB, accessed online at https://www.ecb.europa.eu/ecb/pdf/orga/escbstatutes_en.pdf.

One option to reflect one of the major expenses in an average household’s budget would be to include housing costs directly into the HICP (see ECB 2016 for more details on this issue). Rather than adding asset prices to a consumption good and services’ prices index such as the HICP, we will opt for giving a greater role to changes in the amount of money; so that we can capture the effects of monetary policy on asset prices over the medium to the long term.

One option being the adoption of a zero rate of inflation. Following the seminal estimate of this bias for the US economy back in the 1990 s in the ‘Boskin report’ (see Boskin Commission 1996), estimates of the inflationary bias of the CPI have been made since then for other economies, varying from one to two percentage points. Therefore, targeting a zero rate of inflation, as measured by the CPI, would actually mean the adoption of a one to two per cent rate of deflation.

‘A price-level targeter, by contrast, commits to reversing temporary deviations of inflation from target, by following a temporary surge in inflation with a period of inflation below target; and an episode of low inflation with a period of inflation above target’ Bernanke (2017).

Of course, this strategy would allow the ECB to revisit and explain to the public what ‘price stability’ means, as mandated in its Statutes. In principle, there is no explicit rule preventing the ECB from adopting a mildly deflationary inflation target (i.e. −1%) in the context of a growing economy.

Even more so if the central bank adopts a nominal income level target, which would force the central bank to restore the level of nominal income prior to the crisis. If the pre-crisis spending levels were not sustainable over the long term (i.e. distortionary), the adoption of the same target would actually mean the running of an aggressive inflationary monetary policy, thus accelerating the recurrence of a series of ‘boom and bust’ cycles.

This is released on a quarterly basis, though in the last few years national statistics offices publish monthly GDP estimates with a two-month delay.

A similar argument has been made by Issing (2020) against the case for rising the ECB’s inflation target above 2%.

In Fig. 2, we have used the two-year moving average of nominal GDP growth and M3 growth to extract the medium-term information in the series.

We have calculated in Fig. 2 a so-called Friedman’s ‘K per cent rule’, compatible with the definition of price stability by the ECB (no more than 2% annually), a 2% trend growth of output in the Eurozone and a secular decline of money velocity of −1% per year. The difference between the prescribed M3 growth and the registered M3 growth can be taken as a proxy of the ‘money gap’ in the economy.

According to the seminal work by Friedman (1970), the excess in money growth will first affect output in the short term (6–9 months) and prices later (12–18 months). As stated in Congdon (2003; 2005), an excess in cash balances (particularly in financial companies portfolios) will first bring asset prices up in the very short term, and later affect output and consumer prices to an extent that also depends on the stance of the economy; that is, on the value of the output gap.

This is one of the main reasons why we would support the review of the current definition of price stability by the ECB, so it is not only based on the HICP measure but on a broader monetary measure.

See Christensen (2020) for an excellent analysis of COVID-19 as a supply-side crisis and why its effects (and duration) will be very different from a demand-shock to the economy.

Notably, a monetary strategy that does not incorporate the analysis of monetary developments in the making of policy decisions would be unable to identify these inflationary pressures; therefore, increasing the risk of running too expansionary monetary policies with destabilising effects over the medium and long term. See Castañeda and Congdon (2020) for a more detailed analysis of the current surge in money growth in leading economies and its expected impact on prices and the business cycle in the next two/three years.

See Jarocinski and Lenza (2016) for a survey of the estimates of the output gap for the Eurozone both before and after the Global Financial Crisis. Even though there are significant changes in the size of the gaps, they all share the same message as regards the trend of the output gap and most on its direction too: higher in 2007 by roughly 1% to 5%; and lower in 2014 by −2 to −6%.

Taylor (2009) and Selgin et al. (2015) make a similar assessment of monetary policy in the USA but using estimates of (policy) interest rates rather than money growth.

As we know, these prices are not included in a conventional consumer prices index such as the HICP and thus did not directly feature in the ECB’s definition of price stability. In the next section, we suggest a reform of the ECB strategy that does consider more explicitly the effects of money growth on CPI prices and also asset prices.

Up to 2015, the ECB’s lending facilities to banks in the Eurozone did increase its balance sheet and bank reserves, but not the amount of money in the economy. In a deflationary period with high uncertainty, there was an increase in the demand for money for precautionary motives. In addition, banks had to increase their regulatory capital by 60% (according to the new Basel III regulations, see Ridley 2017), which constrained their ability to expand their balance sheets and added even more deflationary pressures to the economy (see Congdon Castañeda and Congdon 2017). In this context, changes in the balance sheet of the ECB or in the monetary base of the economy (i.e. cash in circulation and bank reserves) do not explain changes in the amount of money in the economy, nor inflation.

This is the distinction made in Congdon (2010) between narrow QE operations (in which the central bank buys assets from the banking sector and only increases the monetary base as a result) and broader QE operations (in which the central bank buys assets from other non-bank financial intermediaries and the Government, and thus increases the amount of deposits in the economy).

In the current COVID-19 crisis, M3 growth in the Eurozone has very much exceeded this range (at the time of writing, July 2020, it is close to 9% annual rate of growth). This would signal the likely return of an inflationary boom in the Eurozone in the next two or three years, unless the ECB takes firm actions in the second half of 2020 to keep monetary growth in check.

In these circumstances, an excess of money growth may be offset by a fall in money velocity, therefore not showing inflationary effects for some time. However, once the level of uncertainty (and thus the demand for money) returns to more normal patterns, we would expect money velocity to revert to its long-term trend and the excess in money balances to affect prices and spending. In the context of the expected effects of the surge in money growth in the USA since March 2020, Congdon (2020) uses US data to confirm the reversion of money velocity to its trend.

In the proposal, it is suggested that up to 30% of the public debt of each Member State is guaranteed by the whole Eurozone. This would be the debt which the ECB would be free to buy in case needed for monetary policy purposes. See De Grauwe and Moesen (2009) for the proposal of Eurobonds in the midst of the Eurozone crisis.

See the historical evidence on this in Bordo and Lane (2013).

This is in line with Issing (2020), who suggests the adoption of a longer time horizon so financial stability concerns can be incorporated into the design of monetary policy decisions.

This does not mean that the policymaker is just following this metric to make decisions. It is merely a useful communication tool to summarise and convey the message to the public.

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Titel: A Rule-Based Monetary Strategy for the European Central Bank: A Call for Monetary Stability
verfasst von: Juan E. Castañeda
Verlag: Springer International Publishing
Buch: New Challenges for the Eurozone Governance
Print ISBN: 978-3-030-62371-5

Electronic ISBN: 978-3-030-62372-2

Copyright-Jahr: 2021
DOI: https://doi.org/10.1007/978-3-030-62372-2_5